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July 1993

Courts in two states reaffirm the requirement of privity for accountants' liability.

by Augenbraun, Barry S.

    Abstract- The highest courts in two states used the doctrine of privity as basis for their decisions limiting the legal liability of accountants. According to the decisions reached by the California Supreme Court in 'Bily v. Arthur & Young Co' and by the New York Court of Appeals in 'Security Pacific Business Credit Inc v. Peat Marwick Main & Co,' an auditor is not liable to a third party who used audited financial statements. The resolution of the cases limits claims only to entities that are in direct privity with accounting firms, particulary the accountants' clients. Of greater significance, however, is the more far-reaching implication of the cases. The decisions shed light on the issues of increasing professional liability burdens being exerted on accountants, the unreasonable demands being imposed by users and the potentially destructive effects of unlimited liability. It is hoped that other courts will be more sober and thoughtful in deciding on similar cases.

The Courts Look at Privity

Both decisions - the California Supreme Court decision in Bily v. Arthur Young & Co., 11 Cal. Rptr. 2d 51 (1992), and the decision of the New York Court of Appeals in Security Pacific Business Credit, Inc. v. Peat Marwick Main & Co., 79 N.Y. 2d 695 (1992) - addressed the specific question of whether an auditor can be found liable to a third party, not his client, who allegedly relied on audited financial statements.

The courts made their decisions in the context of the legal doctrine of privity, which courts have contended with since the beginning of the century. In the earliest development of Anglo-American law, liability for negligence turned on the relationship between the parties. The rule of privity indicated that one who is negligent did not have liability to the world at large for the consequences of that negligence; rather, the party seeking recovery had to show he had a close enough relationship to the wrongdoer to justify the imposition of liability. It was not until the early 20th century that Chief justice Cardozo of the New York Court of Appeals began the "assault on privity" in a celebrated group of cases which resulted in substantially expanding the scope of negligence liability.

Thus, in MacPherson v. Buick Motor Co., 217 N.Y. 382 (1916), the court was called upon to consider whether the purchaser of a car could sue the manufacturer for negligence. Under the doctrine of privity as it had been interpreted, the claims of the plaintiff would have been limited to recovery from the car dealer who had sold him the car, not the ultimate manufacturer. Justice Cardozo held that in the case of a product that was sent out into the stream of commerce, the manufacturer must assume liability for negligence to all reasonably foreseeable users. Six years later, in Glanzer v. Shepard, 233 N.Y. 236 (1922), justice Cardozo extended the doctrine to apply to those who provide services to third parties. In this case, the court held a that public bean weigher who gave certificates of weight to his client was liable to the purchaser of the beans for a deficiency in weight, even though the bean weigher never had a contractual relationship with the buyer.

Based on this progression of cases, it is safe to say the accounting and professional communities faced with some trepidation the forthcoming decision of Chief Justice Cardozo in Ultramares Corp. v. Touche Niven & Company, 255 N.Y. 17 (1931). The case involved a factor that had advanced money to a company after receiving audited financial statements. When the company's accounts receivable turned out to be fraudulently inflated, the factor sued the auditors.

Drawing back from what would appear to be the clear direction of the earlier cases, Chief Justice Cardozo held an accountant can be liable in negligence only to his client. To hold otherwise, he stated in a famous formulation, would expose professionals to potential liability completely out of proportion to the degree of fault:

If liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft or forgery beneath the cover of deceptive entries, may expose accountants to a liability in an indeterminate amount for an indeterminate time to an indeterminate class. The hazards of a business conducted on these terms are so extreme as to enkindle doubt whether a flaw may not exist in the implication of a duty that exposes to these consequences.

The power of Justice Cardozo's reasoning - and the enormous influence of his views on the whole body of American law - established the rule of privity as the law of the land, virtually without challenge, for almost 40 years. Beginning in the late 1960's, however, courts around the country began to grow uncomfortable with this narrow approach to liability. Recognizing the widespread importance of auditors' reports in commercial and investment decisions, these courts developed a number of different formulations designed to expand the extent of an auditor's liability. Between 1968 and 1988, a majority of American courts adopted the so-called "restatement rule" as formulated in the Restatement (Second) of Torts, Sec. 552. This formulation provides for liability of the auditor to one of a "limited group of persons for whose benefit and guidance the auditor intends to supply the information or knows that the recipient intends to supply it." This formulation is generally understood to mean the auditor can be liable to those persons whom he foresees will be relying on his work product.

An even more expansive formulation adopted by other courts established liability to those persons whom the auditor should "reasonably have foreseen" would rely on his work product.

The New York Decision

Whether because of the logic of Justice Cardozo's decision in Ultramares or his abiding influence on New York law, the New York Court of Appeals remained the most steadfast guardian of the privity rule with respect to accountant's liability. Even in New York, however, the Court of Appeals found itself forced to step back from the rule of absolute privity, which precludes all claims for negligence by anyone other than the client. In Credit Alliance v. Arthur Andersen & Co., 65 N.Y. 2d 536 (1985), and its companion case, European American Bank v. Strauhs & Kay, the Court concluded a third party can recover for negligence if the accountant was aware the financial statements were to be used for a particular purpose on which known parties were going to rely, and there was "some conduct on the part of the accountants linking them to that party or parties which evinces the accountant's understanding of that party or parties' reliance." In the European American Bank case, the Court held that because the accounting firm had made direct and repeated communications to the bank with respect to the audit and the company's financial statements, the parties had developed a relationship "sufficiently approaching privity."

Against this background, the Court in the recent Security Pacific case faced the question of how much contact with the auditor creates liability in negligence to a third party. In this case, the accountants had furnished a "pencil draft" of the financial statements to their client, who sent the pencil draft to a bank vice president. The bank officer then called the audit partner at the accounting firm to discuss the status of the audit, and also discussed with him the Company's income and the adequacy of reserves for accounts receivable as reflected in the financial statements. The accountants assured the bank officer they were "comfortable" with the financial statements and would be issuing their unqualified opinion in final form shortly - as they in fact did.

When the company failed and the loan went bad, the bank sued the accountants who responded with the defense of lack of privity and lack of sufficient contact to create liability. The majority of the Court of Appeals concluded that one telephone conversation was not sufficient to bring the bank within the ambit of those who are "sufficiently approaching privity" with an accountant for purposes of asserting a negligence claim under New York law. The court goes to great lengths to distinguish the "single phone call" in this case from the "multiple, direct and substantive communications and personal meetings" which gave rise to liability in the European American Bank case. Furthermore, the court pointed out "there is no evidence Main Hurdman predecessor to Peat Marwick Main & Co. shaped its 1984 audit opinion to meet any needs" of the lender. On the other hand, in European American Bank, there was constant contact between the accounting firm and the prospective lender and continued discussions with respect to the scope of the audit.

As a result of the Court's opinion, it is clear it takes more than a single phone call to the auditor from a potential user of the financial statements to meet the "near privity" requirement of New York law. But how much more does it take? As Judge Hancock pointed out in a vigorous dissent, the Court of Appeals has not explained what would constitute sufficient "conduct evincing an accountant's understanding of a third party's reliance" to meet the requirements of New York law. In his view, the lender had certainly done enough under the Credit Alliance standard to put the accounting firm on notice of its intended reliance on the financial statements, and the nature of the issues that would be of importance to it as a prospective lender. In his view, the Court of Appeals has, in effect, reversed the "near privity" standard and returned - without announcing it clearly - to the absolute privity standard of Ultramares.

The California Case

While the New York Court decisions supporting, or severely limiting, the doctrine of privity are understandable in the context of justice Cardozo's abiding influence, the California Supreme Court's decision is quite remarkable. California has long been known as a jurisdiction in which expanded theories of liability are given serious attention by the courts and often supported. A 1986 intermediate Court of Appeals decision, International Mortgage Co. v. John P. Butler Accountancy Corp., 177 Cal. App. 3d 806 (1986), adopted the most expansive rule of "reasonable foreseeability" as the applicable standard for determining the extent of an auditor's liability for negligence. Nevertheless, the Supreme Court of California concluded in Bily that the rule to be adopted in California was that of strict privity; only the auditor's client can sue for negligence.

The plaintiffs in Bily were sophisticated venture capitalists who had acquired warrants to purchase stock of Osborne Computer Corporation in a private placement. One of them was a member of Osborne's board of directors who purchased stock from the company's founder. None of the plaintiffs had any contact with the auditor prior to their investment, nor was there any evidence the auditor was aware of their identity or of the specific transactions in which plaintiffs exercised their warrants and purchased common stock.

The plaintiffs sought recovery for both negligence and negligent misrepresentation. In an opinion that clearly was influenced by the spectre of the continuing expansion of professional liability litigation, the Supreme Court of California rejected the expansive rule adopted by the lower court and concluded the strict rule of privity was required to protect accountants from an unreasonable expansion of liability.

The court began with a detailed discussion of the nature of the audit process which is clearly sympathetic to the difficult professional judgments faced by the auditor:

For practical reasons of time and cost, an audit rarely, if ever, examines every accounting transaction in the records of a business. The planning and execution of an audit therefore require a high degree of professional skill and judgment.

For this reason, an audit report is "not a simple statement of verifiable fact like the weight of a load of beans" in the Glanzer case.

Rather, an audit report is a professional opinion based on numerous and complex factors .... Although ultimately expressed in shorthand form, the report is the final product of a complex process involving discretion and judgment on the part of the auditor at every stage. Using different initial assumptions and approaches, different sampling techniques, and the wisdom of 20-20 hindsight, few CPA audits would be immune from criticism.

The court then points out it is the client which has primary responsibility for preparation of the financial statements and the client which has the control over the information made available to the auditor - "the information base for the audit." For this reason, it is the client - not the auditor - which should face primary responsibility for any errors.

Starting from this sympathetic view of the audit process, the Court then re-examines the standards for negligence liability applied in different jurisdictions: the privity rule, the restatement rule, and the "reasonably foreseeable" rule. Concluding that any other rule would create liability out of all proportion to fault, the Court adopts the rule of absolute privity as the applicable standard for liability for negligence; the auditor can be liable only to his actual client for negligence. In language that clearly harks back to Justice Cardozo's words, the Court concludes that any other approach "raises the spectre of vast numbers of suits and limitless financial exposure."

Recognizing that such a view appears at odds with the expansion of liability in other areas, such as products liability, the Court argues that users of financial statements tend to be sophisticated business enterprises that are able to conduct their own investigation of the client's financial statements directly, or through auditors of their own choosing. As a matter of policy, the Court concludes these sophisticated users should be encouraged to rely on their own "prudence, diligence, and contracting power" for the information they consider important.

The Court does, however, provide an avenue for third party users to press a claim against an accounting firm. While liability for negligence is limited to the actual client, the auditor does have liability for "negligent misrepresentation" to those persons who are actually foreseen by the auditors as users of the financial statements and who can prove reliance. In California, the tort of "negligent misrepresentation" is actually a form of fraud, rather than a category of negligence. However, it remains to be seen whether the Court's adoption of the Restatement Rule in the case of negligent misrepresentation may represent a loophole that will eventually swallow up the beneficial results of the basic holding which limited exposure for negligence solely to the actual client.

The Importance of the Decisions

The importance of these decisions lies both in their actual result and in their symbolic impact. For accounting firms, the issue of who can sue for negligence is a vital issue. By limiting claims to those who are in direct privity with the accounting firm, these decisions define important limits to the extent of professional liability.

The symbolic significance of these decisions goes far beyond the actual holdings, however. The highest courts of the two most significant legal jurisdictions in America have clearly sent out a warning that the ever increasing spiral of professional liability has reached a point of danger, if not Crisis. The extensive discussion in these decisions of the difficulties faced by the accounting profession, the unrealistic demands imposed by users, and the devastating impact of unwarranted liability - will provide material for sober and thoughtful consideration by other courts around the country when these compelling decisions are brought to their attention.

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